All About Roth IRAs and How They May Change
Advice from the 'Friends Talk Money' podcast on what could happen to 'backdoor' Roth IRAs
In the beginning, well 1974 to be exact, Congress created the Individual Retirement Account, or IRA. And it was pretty good — as a way of helping Americans save for retirement and save on taxes along the way. In 1998, the Roth IRA came along, an alternative whose withdrawals in retirement are tax-free. Now, Congress and the Biden administration might be changing the Roth IRA rules. You'll want to know what's up and what it could mean for you.
My "Friends Talk Money" podcast co-hosts and I just released a new episode on exactly that, as well as how Congress is considering making it easier for some employees to save for retirement. (You can hear the episode wherever you get podcasts or at the end of this article.)
If you had invested $2,000 in the Dow Jones stocks in IRA in 1982, you'd have $58,491 today.
"People love the Roth IRA" because the money comes out tax-free, although there's no upfront deduction as there often is for traditional IRAs, co-host Pam Krueger, founder of the financial advisor vetting site Wealthramp said in the podcast.
She's right. There's more than $1 trillion in Roth IRAs and in 2017, $23.5 billion flowed into them, more than the $18.8 billion contributed to traditional IRAs, according to a Congressional Research Service report. About 54% of people 45 to 54 with IRAs own Roth IRAs.
The Roth IRA Rules
If you have employment income, your gross income is under $125,000 and you're single (under $198,000 if you're married filing jointly), you can invest up to $6,000 in a Roth IRA; $7,000 if you're 50+. The maximum contribution is lower if your income is $125,000 to $140,000 and you're single, $198,000 to $208,000 married filing jointly; above those thresholds you can't put money into a Roth IRA.
Stashing money in an IRA can really pay off over the long-term.
"Friends Talk Money" podcast co-host Terry Savage, a syndicated personal finance columnist and author, said that if you had invested $2,000 in the Dow Jones stocks in IRA in 1982, you'd have $58,491 today. (By contrast, if you had put the $2,000 in a one-year bank CD IRA in 1982 and rolled it into a new CD each year, you'd only have about $6,715 now.) Money invested in traditional IRAs and Roth IRAs isn't taxed when it's in the accounts.
But the Biden administration and some in Congress think there are shenanigans going on with Roth IRAs.
Specifically, they're concerned about what are known as "backdoor IRA conversions" and "mega-backdoor IRA conversions" with 401(k) plans.
Backdoor IRA conversions let people with traditional IRAs swap them for Roth IRAs to save on taxes once they withdraw the money — even if they now earn more money than the normal income threshold for Roth IRAs.
They've become a "mainstay financial-planning strategy for upper-middle-income and upper-income investors," Morningstar director of personal finance Christine Benz recently wrote.
As Krueger said on the podcast, "A backdoor Roth conversion sounds kind of shady, but it isn't. It's just a workaround to get the money from your traditional IRA into a tax-free Roth in order to avoid paying tax at the end, when you start taking withdrawls."
What's a "Mega-Backdoor" IRA Conversion?
"Mega-backdoor" conversions are done through 401(k) plans and let people contribute an extra $38,500 a year even when they exceed the normal Roth IRA limits.
"A backdoor Roth conversion sounds kind of shady, but it isn't."
Congress is looking at both types, "trying to make the uberwealthy pay more of their fair share of taxes," Rahul Kothari, managing director of Ironview Capital Management in Philadelphia, told "Friends Talk Money." One mega-stat: Nearly 500 taxpayers had at least $25 million each in Roth IRAs in 2019.
House Ways and Means Chairman Richard Neal (D-Mass.) put it this way: "Incentives in our tax code that help Americans save for retirement were never intended to enable a tax shelter for the ultra-wealthy. We must slow down these practices."
Another reason Democrats want to clamp down on backdoor IRA conversions: the changes would bring the government an estimated $749 million over 10 years and help pay for the president's Bring Back Better proposals.
Kothari said the proposed "mega" backdoor Roth IRA conversion concern is sometimes called "the Peter Thiel rule." That's because, as the ProPublica website reported, PayPal founder Peter Thiel put $1,700 in founder's shares into a Roth IRA in 1999, each worth just a tenth of a penny. Since then, the site said, he's turned his Roth IRA into a "$5 billion tax-free piggy bank."
3 Roth IRA Changes Congress Is Considering
Democrats in Congress are eyeing making three changes to the Roth IRA rules:
- "Mega" backdoor Roth IRA conversions would be halted as of January 2022.
- All Roth IRA conversions would be banned beginning in 2032 for single people earning more than $400,000 and married ones whose incomes exceed $450,000.
- And most people with retirement account balances over $10 million would be required to take distributions, regardless of their age; currently, Roth IRAs have no required distributions, as traditional IRAs do, starting at 72.
"I would be surprised if they started going after people who have far less in their Roth IRA accounts."
Should you worry if you have less income or retirement money than what's noted in these proposals? Kathari doesn't think so. "I would be surprised if they started going after people who have far less in their Roth IRA accounts," he said.
Savage noted, however, that this isn't an ideal time to convert a traditional IRA to a Roth IRA. "When would you do it? You would not do it at the top of a bull market," she said. "The time to do it is when the market is crashing."
That's because the value of your stocks would be lower then, so you'd owe less in taxes at the time of conversion.
401(k)s or IRAs for Employees Without Retirement Plans
I also mentioned on the podcast one other retirement-savings change Congress is looking at: requiring employers with more than five employees and which are more than two years old but don't have 401(k) plans to either offer 401(k)s or IRAs starting in 2023 or get taxed $10 per day per worker. Right now, only about half of workers have access to 401(k)-type plans.
Meantime, if you've been considering making a Roth conversion with your IRA or 401(k), you may want to do it in 2021 under the current rules.
If the backdoor does get shut and you work for an employer with a high-deductible health insurance plan, you might then want to put money into a tax-free Health Savings Account or HSA. The Next Avenue article "How to Use a Health Savings Account in Retirement" offers a primer on how HSAs work.